Qualified retirement plans include terms you are probably already familiar with: 401(k)s and traditional pensions. While a number of other qualified plans exist, such as SEPs and profit sharing plans, 401(k)s and traditional pensions demonstrate very well the two major subcategories of qualified retirement plans: defined contribution plans and defined benefit plans.
Defined contribution plans are the most common plans created today. These plans dictate that employers give a certain “contribution” to employees each year, which those employees may then invest. Employees may contribute to these plans as well, and employers can “match” employee contributions. Such features are common in 401(k) plans.
Did you know? Defined contribution plans place the investment risk of loss on the employee, not the employer.
Therefore, the employer simply makes a contribution, and if the contribution is invested for a net loss, the employee loses that retirement benefit. Defined contribution plans, by shielding employers from this risk of loss, are typically appropriate for many businesses with either a high number of employees or a small annual net profit.
Defined benefit plans are the “original” retirement plan. A defined benefit plan requires employers to pay a certain benefit to employees each year which cannot be diminished. This is known as an “accrued benefit.” The employer pools all employees’ accrued benefits into a single account (in most cases) and handles the plan’s investment activities. Each year, employees in the plan will accrue (earn) a certain amount of new benefits, which means the employer must make annual contributions to the plan to reflect those earnings. If the plan is invested for a net gain, the annual contribution will be lower because the plan will already consist of the assets previously accrued by employees plus the net gain on investment. This means that investment gains lower annual funding contributions for employers. Naturally, if the plan suffers an investment loss, the annual funding contribution will be higher, reflecting the fact that the employer must fund for this year and cover last year’s losses. Remember, an accrued benefit cannot be diminished. The employer must make up for investment losses, and thus bears the risk of loss.
Did you know? Though it may seem that defined benefit plans will never be favorable due to the risk of loss allocation, these plans offer a number of benefits that keep them in use today, especially with businesses which have a small number of employees but a high annual net profit.
First, defined benefit plans are heavily favored amongst knowledgeable, key employees because they provide a better guaranty of retirement benefits than a defined contribution plan. Thus, defined benefit plans better attract, retain, and motivate employees.
Second, certain businesses, such as those with a small number of employees and a high annual net income, see great ancillary tax and business planning advantages coupled with a minimal exposure to the risk of loss in a defined benefit plan. Properly constructed and administrated, defined benefit plans offer much more powerful ancillary benefits than a defined contribution plan.
Did you know? While you can be shielded from some liability as a plan sponsor, you can never be fully protected nor contract that liability away. A recent Department of Labor Field Assistance Bulletin, No. 2012-02, notes that employers are always liable as fiduciaries for plans, even on self-directed brokerage accounts. What this means is that, despite the unfortunately common claims from numerous service providers in the industry, as an employer, you always remain liable for your retirement plans. Claims from other service providers that they will “take liability” for your plan are not true and can be dangerous and damaging to your business as a result. Be sure to treat service providers who make such claims to you with extreme caution, and always consult an employee benefits attorney before creating a new plan and subjecting yourself to fiduciary liability.
Case example: Tussey v. ABB, Inc.: The defendant employer was found to have breached its fiduciary duty to monitor its administrators and investment advisors by creating a “set it and forget it” 401(k).